The privilege of becoming debt-free when able

A buyer negotiating to acquire a parcel of real estate generally needs additional capital to pay the purchase price. The capital will be raised through mortgage financing. A note will be prepared and signed to evidence the debt created.

As with any arrangement for debt, provisions in the note set out a payment schedule for the return of principal, typically through amortized reduction of the mortgage balance and final payoff.

The note’s payment schedule provision contains an “or more” clause. The “or more” wording allows for payment of unscheduled principal reductions by the buyer – unless otherwise restricted in provisions added to the boilerplate copy of the note. [See first tuesday Form 420 §2]

The buyer may deleverage by voluntarily reducing principal using the “or more” wording, either periodically or in one payment. Here, the mortgage holder may not force an increase in principal reduction by a call so long as the buyer:

  • pays no less than the scheduled payments; and
  • does not trigger an incurable breach.

Managing the premature receipt of principal

On the flip side of the buyer’s use of the “or more” clause is the mortgage holder’s various desires not to have the principal prepaid.

Two methods exist for meeting this objective:

  • the removal of the “or more” clause from the payment schedule provision; or
  • the inclusion of a prepayment penalty provision to recover costs and losses due to any principal reduction beyond the scheduled payments.

To strike and remove the “or more” clause from the note locks in the buyer to paying only the principal as scheduled. Without an “or more” clause, the buyer is barred from voluntarily prepaying any portion of the principal other than by the installments set in the note’s payment schedule. As a result, the owner’s inability to pay off mortgage debt becomes a restraint on their ability to sell or further encumber their property.

Thus, the mortgage holder’s most practical method for managing their premature receipt of principal is to include provisions for a charge on a prepayment of extra principal. The amount of the charge is based on the amount of principal prepaid, and continues for a sufficient number of years to justify originating the mortgage. Such an arrangement is called a prepayment penalty provision.

When preparing a note and trust deed to document a mortgage, the prepayment penalty provision is included in the note. The provision is not included in a trust deed since a trust deed is a security device and relates to the care, maintenance and foreclosure of the mortgaged property, not the terms of the debt.

Debt reduction: deleveraging inhibited

The unscheduled prepayment of any mortgage principal before it is due is ironically considered a privilege.  When an owner of a mortgaged property is able to deleverage by paying off the mortgage holder early, they typically need to pay a premium to become debt free.

When a prepayment penalty provision exists in the note, the mortgage holder is able to charge the owner on each exercise of the principal reduction privilege, whether the reduction is a portion or all of the  remaining principal balance on the debt.  [See first tuesday Form 418-2]

Historically, lenders and mortgage holders used prepayment penalties to prevent the loss of interest income until the funds were re-lent to another borrower. That is no longer the reason for a loss caused by a premature principal reduction.

Economic reality

Over the years, California courts have embraced a number of rationales which support mortgage holder enforcement of the prepayment penalty. However, for each justification offered by mortgage holders in support of prepayment penalties, a counter-argument exists:

  1. Administrative costs: The net costs and the loss of profit a mortgage holder incurs on the unscheduled reduction of principal.Penalties allow mortgage holders to recoup costs they will incur when making new mortgages with prepaid funds up-front. Income such as mortgage origination fees and charges always offset costs incurred to re-lend principal to fund new mortgages. [Hellbaum v. Lytton Savings and Loan Association (1969) 274 CA2d 456]
  1. Lag time: The loss of interest income due to money sitting idle between payoff and re-lending.Cash on hand does not sit idle in today’s lending institutions. Prepaid funds are promptly re-invested in short-term securities until placed again in long-term mortgages. [Lazzareschi Investment Company v. San Francisco Federal Savings and Loan Association (1971) 22 CA3d 303]
  1. Mortgage holder profitability: Use of the prepayment penalty as a mortgage portfolio yield maintenance device.When mortgage holders call or modify mortgages on the transfer of the mortgaged property using the due-on clause, they do so only because they can re-lend the money at higher rates.They welcome the prepayment of fixed rate mortgages (FRMs) in markets of rising interest rates (as we will experience for decades after 2015), when it higher rates increase mortgage holders’ portfolio yield boosts profitability. Thus, the prepayment penalty charge becomes bonus windfall earnings.
    It is argued mortgage holders have the right to collect prepayment penalties in a declining interest rate market. However, this argument is inapplicable when interest rates are rising, as will occur well into the 2030s. However, prepayment penalty provisions are in both scenarios, an asymmetric application of their purpose. If penalties are justified at all, it is only during periods of falling interest rates.  [Lazzareschi Investment Company, supra]
  1. Mortgage holder expectations: Disruption of a mortgage holder’s commitment to a long-term placement of funds.Mortgage holders expect mortgages to be paid prior to maturity. Mortgage holders consider the risk of prepayment when setting interest rates or assessing the value of a mortgage portfolio, especially for servicing agreements. The industry-standard long-term projection shows the average mortgage prepays by its twelfth year.
    In California in the 1990s, the average was a mere five years due to several periods of increased mortgage refinancing as rates constantly declined. That low average was seen again in the mid-2000s as home values soared and refinancing conditions converted real estate equities into proverbial ATMs.
    Such turnover generates profits from mortgage origination fees, points and interest rate adjustments. It is reasonable to assume prudent mortgage holders base their annual profit projections on portfolio turnover.Further, with the predominant secondary mortgage market, many mortgage lenders pool and sell their mortgages to other mortgage holders on an advantageous change in interest rates. They generally do not own mortgages with the intent of obtaining long-term income; rather, they service them for that income and not the occasional prepayment penalty revenue.  [Lazzareschi Investment Company, supra]
  1. Loss due to declining market rates: Income lost due to prepaid funds being re-lent at lower interest rates than originally bargained with the borrower.For the declining market argument to succeed, penalties are appropriate only when market rates drop below that of the prepaid mortgage, and only when the various front-end charges, points accruing over the life of the mortgage and the mortgage holder’s cost of funds at the time of the prepayment are also taken into consideration. [Sacramento Savings and Loan Association v. Superior Court (1982) 137 CA3d 142]

Disclosure — Fred Crane, first tuesday’s Legal Editor, was the attorney of record on Sacramento Savings and Loan Association v. Superior Court.

Thus, in all but the rarest situations — such as a catastrophic fall in long-term interest rates without an immediate corresponding decrease in the cost of funds — mortgage holders are unable to show they experience losses due to an early payoff.

Consumer mortgages and diminishing returns

Prepayment penalties were a popular tactic mortgage holders used in the Millennium Boom era to lock inexperienced owners into dangerously expensive mortgages. Inadequate disclosures left many owners unaware of the potential for their interest rates and payments to increase dramatically.

When deceptively low teaser rates expired or negative amortization swelled their principal balance, owners found themselves trapped in mortgages they were never able to afford to begin with. Prepayment penalties only increased an owner’s inability to refinance into a more reasonable arrangement. Defaults and foreclosures exploded in 2007, setting the cascade of the financial crisis in motion.

In response to those abuses and the resulting toxic economic ripple effect of the 2008 Financial Crisis and ensuing Great Recession, prepayment penalties on consumer mortgages were re-regulated in 2010, along with enhanced disclosure requirements and other consumer protections added to an expanded Reg Z.

Editor’s note—A consumer mortgage is a residential real estate loan which funds a personal, household or family use.

Related article: Ability-to-repay, qualified mortgage and qualified residential mortgage, oh my!

Reg Z sharply curbs the use of prepayment penalties for consumer mortgages, limiting the charge amount during the first three years of the mortgage, which is reviewed in detail below.

As for business mortgages (all mortgages not serving a consumer purpose), prepayment penalty and lock-in negotiations are not controlled by Reg Z. Further, business mortgage originations are considered arms-length transactions arising out of relatively equal bargaining positions. Thus, prepayment provisions in business mortgages are not currently subject to legislation or regulation—just judicial review for unreasonable charges.

New controls for consumer prepayment penalties

In the renewed regulatory era, prepayment penalties on consumer mortgages are now prohibited unless the mortgage is a qualified mortgage meeting Reg Z’s ability-to-repay rules (together, ATR-QM) and does not include the following terms:

  • an adjustable rate of interest (an ARM); or
  • an annual percentage rate (APR) greater than the average prime offer rate (published by the Consumer Financial Protection Bureau [CFPB]) for a comparable residential mortgage loan by:

o   1.5% on a first mortgage with a principal within conforming loan limits set by the Federal Home Loan Mortgage Corporation (Freddie Mac);

o   2.5% on a first mortgage with a principal above conforming loan limits set by Freddie Mac; and

o   3.5% on a second or other subordinate mortgage.

Editor’s note — As of 2014, Freddie Mac’s baseline limits for conforming loans were:
$417,000 for a single-family property;
$533,850 for a two-unit property;
$645,300 for a three-unit property; and
$801,950 for a four-unit property. [Freddie Mac Bulletin 2013-25]

Prepayment penalties are also prohibited for Section 32 high-cost consumer mortgages, which are consumer mortgages which exceed the average prime offer rate for similar mortgages by 6.5% for a first trust deed on a borrower’s primary residence with a principal amount exceeding $50,000. [12 CFR §§1026.43(g)(1); 1026.32(d)(6)]

Prepayment penalty on QMs

When a prepayment penalty is allowed on fixed rate consumer mortgages classified as QMs, the penalty period is limited to three years after origination.
Further, the amount of the prepayment penalty may not exceed:

  • 3% of the outstanding balance during the 1st year;
  • 2% of the outstanding balance during the 2nd year; and
  • 1% of the outstanding balance during the 3rd year.

A mortgage lender who intends to include a prepayment penalty provision when offering to make a qualified fixed rate consumer mortgage is also required to offer a comparable, alternative mortgage arrangement without a prepayment penalty provision.

Thus, when a prepayment penalty is involved in a consumer mortgage it will be a QM with a fixed rate. The mortgage lender or mortgage loan originator (MLO) seeking a prepayment penalty needs to offer two comparable mortgages: one with the prepayment penalty, and one without. [12 CFR §1026.43(g)(3)]

Enforceable penalties for business and consumer carryback mortgages

Prepayment penalties are not permitted for consumer mortgages of any kind, unless they meet the fixed rate qualified mortgage (QM) definition.

This rule applies to all consumer carryback mortgages. If a carryback seller wishes to include a prepayment penalty provision in their consumer carryback mortgage the seller needs to comply with QM requirements, including verification of the buyer’s ability to repay, caps on points and fees, maximum debt-to-income ratio and more.

Business mortgages secured by owner-occupied, one-to-four unit residential property are required to permit prepayment of up to 20% of the original principal balance in any 12-month period without penalty. When more than 20% of the original amount of the note is prepaid in a 12-month period, the penalty on the excess is limited to six months’ advance interest at the note rate. [Calif. Civil Code §2954.9(b)]

For business mortgages not secured by owner-occupied, one-to-four unit residential property, a prepayment penalty is enforceable if the amount is reasonably related to money losses actually suffered by the mortgage holder on prepayment. Reasonably related money losses include the payment of profit taxes incurred by a carryback seller on a premature reduction in principal or final payoff. [Williams v. Fassler (1980) 110 CA3d 7]

Due-on clause and prepayment penalties

Prepayment penalty provisions in all mortgages containing a due-on clause secured by owner-occupied, one-to-four unit residential property are unenforceable if the mortgage holder:

  • calls the mortgage due for a transfer in breach of the due-on clause;
  • starts foreclosure to enforce a call under the due-on clause; or
  • fails to approve an assumption of the mortgage during the pendency of a sale of the mortgaged property within 30 days of receipt of the qualified buyer’s completed credit application. [12 CFR §591.5(b)(2), (3)]

However, a seller carrying back a mortgage secured by a one-to-four unit residential property is only able to bar prepayment for the calendar year of the sale when they have not already carried back four or more such mortgages in the same calendar year. [CC §2954.9(a)(3)]

If the holder of a mortgage on one-to-four residential units intends to collect a prepayment penalty on a call triggered by a due-on clause, the owner needs to have agreed in a prepayment penalty provision that they waive their right to prepay without a penalty. [CC §2954.10]

Prepayment penalty due on a call

Consider a prepayment penalty clause in a mortgage that calls for a penalty payment on the voluntary or involuntary prepayment of the debt.

The property owner defaults on the mortgage. The mortgage holder records a Notice of Default (NOD), automatically calling the debt due. The owner tenders full payment of the debt excluding the prepayment penalty, which the mortgage holder refuses.

The property owner claims the prepayment penalty clause is only enforceable when the property owner voluntarily prepays the debt, not when the mortgage holder calls the debt due.

Is the prepayment penalty clause enforceable on a full payoff when the mortgage holder calls the debt due?

Yes! The clause permits the mortgage holder to demand a prepayment penalty on an involuntary prepayment resulting from the mortgage holder’s acceleration of the balance due on the debt. [Biancalana v. Fleming (1996) 45 CA4th 698]

Further, consider a property in foreclosure. The mortgage holder records a Notice of Trustee’s Sale (NOTS) which states the amount to pay off the loan includes:

  • unpaid principal balance;
  • accrued and unpaid interest;
  • late charges;
  • foreclosure costs (including attorney and trustee’s fees); plus
  • a prepayment penalty.

At the trustee’s sale, is the mortgage holder able to demand and collect a prepayment penalty charge?

Yes! The mortgage holder’s right to collect a prepayment penalty is set by the provisions of the note, unless prohibited. Since the note provides for a prepayment charge when the loan is either voluntarily or involuntarily prepaid, the mortgage holder’s full credit bid at the trustee’s sale may include the prepayment penalty charge. [Golden Forest Properties, Inc. v. Columbia Savings and Loan Association (1988) 202 CA3d 193]

Conversely, when the mortgage limits a prepayment penalty to only voluntary payoffs, the mortgage holder is not permitted to include the penalty when the property is redeemed or bid on at the trustee’s sale. [Tan v. California Federal Savings and Loan Association. (1983) 140 CA3d 800]

Disclosure — Fred Crane, first tuesday’s Legal Editor, was the attorney of record on Tan v. California Federal Savings and Loan Association.

Tax advantages for the carryback seller

Consider a seller of real estate who is willing to carry back a mortgage for the portion of the purchase price remaining after a 20% down payment and the buyer’s takeover of the seller’s existing mortgage. The seller financing is classified as a business mortgage since the property sold is not a one-to-four unit residence or, if it is, will not be occupied by the buyer’s family or serve as the buyer’s vacation home.

The seller is aware the profit on the carryback note will not be taxed until principal is received or they assign it in a sale of the note or as collateral for other debt.

The seller’s remaining cost basis for the property is less than the balance of the mortgage on the property. Thus, the entire amount of the carryback note will be profit, subject to taxes as principal is paid, due to the seller’s mortgage-over-basis situation.

If the seller receives all cash, and thus is taxed on all profit in the year of the sale, they will pay a combination of federal and California state income tax of up to 33% (2014) on the profit depending on the seller’s income bracket.

If deposited in an interest-bearing account, the balance of the sale proceeds remaining after the payment of taxes will produce interest earnings on less than 66% of the net sales proceeds for the highest income bracket (the other 33% being disbursed to pay taxes).

However, with taxes deferred in an installment sale, the seller will earn interest at the carryback note rate on the full amount of the equity remaining unpaid after the down payment. Profit tax on the amount of “mortgage over basis” debt relief will need to be paid, unless covered by the seller carrying back an all-inclusive trust deed (AITD).

Thus, the seller is motivated to defer taxes on their profit until the carryback note is due. Meanwhile, the seller earns interest on the amount of the deferred profit tax they retain as principal in the carryback note.

A carryback seller’s compensation for an early payoff

Two alternatives exist for the carryback seller of a business mortgage to earn interest income on the portion of the sales price which will eventually be paid in profit taxes:

  • lock the buyer into payments of no more than the scheduled installments by eliminating the “or more” provision in the note and to prevent early payoff of additional principal [See first tuesday Form 420 §2]; or
  • include provisions for a prepayment penalty to be due on the payoff of any principal exceeding scheduled installments.

Consider a seller carrying back a business mortgage who selects the prepayment penalty alternative after their broker voices concern over the enforceability of a lock-in clause. Deletion of the “or more” clause prohibits principal reductions except under regular monthly payments and the final/balloon payment.

The seller wants to include a prepayment penalty of 25% to cover most of the taxes incurred on payoff.

For the carryback business mortgage, a reasonableness standard applies to any prepayment penalty. If the carryback business mortgage is secured by an owner-occupied, one-to-four unit residential property, any prepayment penalty is limited to six months’ advance interest on prepaid principal exceeding 20% of the original balance per calendar year.

Is the carryback business mortgage holder able to enforce a prepayment penalty in the amount of the estimated tax they will pay on their profit if the buyer prematurely pays additional principal?

Yes! A prepayment penalty on a carryback business mortgage is enforceable if the penalty amount is reasonably related to the seller’s anticipated money losses in the form of profit taxes on prepaid principal. Since the anticipated profit tax rate for an unscheduled principal reduction is 33% in the highest income bracket, a penalty in that or a lesser amount when principal is prepaid is reasonable. [Williams v. Fassler (1980) 110 CA3d 7]

QM prepayment penalties are limited to:

  • 2% in the first two years following origination;
  • 1% in the third year; and
  • 0% thereafter. [12 CFR §1026.43(g)(2)]

Reasonableness of the penalty

The reasonableness of the carryback seller’s penalty amount is tested at the time the mortgage is entered into, not at the time of payoff. In the intervening years, interest and tax rates will likely go through major fluctuations, either up or down. [Williams, supra]

Although a prepayment penalty inhibits conveyancing and reconveyancing, it is considered a reasonable restraint on alienation and the owner’s use of the property’s title. [Sacramento Savings and Loan Association, supra]

An exorbitant or unconscionable penalty is unreasonable and thus unenforceable. [Hellbaum, supra]

Prepayment penalty triggered by late payments

Now consider the holder of a business mortgage encumbering real estate other than an owner-occupied, one-to-four unit residential property. The note contains a prepayment penalty provision calling for payment of six months unearned interest on any principal prepaid within six months after origination.

Further, the prepayment penalty is due on a principal prepayment after the first six-month period if any previous regularly scheduled payment was delinquent. The owner makes a regular payment after the grace period for its payment expired, resulting in a delinquency.

After the initial six months and before the final/balloon payment is due, the owner prepays the principal together with the prepayment penalty demanded by the mortgage holder. The owner later makes a demand on the mortgage holder for a return of the penalty payment, which the holder rejects.

The owner claims the prepayment penalty is an unenforceable liquidated damages penalty since it was triggered by a late payment of a regular installment, not an early payoff of the mortgage, and thus was unrelated to losses the mortgage holder incurred on prepayment of principal.

Is the business mortgage holder permitted to enforce a prepayment penalty on a final payoff which was triggered by a prior late payment of a monthly installment?

No! The prepayment provision here is structured to trigger payment of a penalty for having paid a regular installment late, not an early payoff of principal. Thus, the purported prepayment provision becomes an unenforceable liquidated damages provision since the charge bore no relation to the mortgage holder’s losses due to the prior late payment. [Ridgley v. Topa Thrift and Loan Association (1998) 17 C4th 970]